Arbitrage

Arbitrage is a financial strategy that involves the simultaneous buying and selling of related assets or financial instruments to exploit a price discrepancy for profit. Arbitrage opportunities exist due to inefficiencies in markets or pricing disparities between related instruments. Typically, arbitrage is considered risk-free, as it seeks to capitalize on price differences across markets or similar instruments without exposure to the underlying asset's risk.

Types of Arbitrage

Spatial Arbitrage: This involves buying and selling the same asset in different markets to take advantage of differing prices for the same asset.
Temporal Arbitrage: Here, the arbitrageur exploits price differences between the same asset at different points in time.
Risk Arbitrage: This type of arbitrage involves capitalizing on price discrepancies between related securities; for example, buying and selling shares in companies that are involved in a merger or acquisition.
Statistical Arbitrage: Statistical models and quantitative techniques are used to identify short-term trading opportunities.
Covered and Uncovered Arbitrage: Covered arbitrage involves a risk-free profit, while uncovered (or "naked") arbitrage involves some risk.

Mechanics

Identification: The first step is identifying the arbitrage opportunity.
Execution: Simultaneous buying and selling of the identified assets.
Closure: The positions are closed once the price discrepancy is eliminated or reduced to a level where arbitrage is no longer profitable.

Risks Involved

Execution Risk: Delays in trading can negate the arbitrage opportunity.
Price Change Risk: Asset prices may change before both sides of the trade are complete.
Liquidity Risk: Lack of sufficient liquidity can affect the ability to execute trades.
Model Risk: Inaccuracies in valuation models can result in false arbitrage signals.

Market Impact

Price Correction: Arbitrage helps in bringing prices to their “correct” levels.
Increased Efficiency: It makes markets more efficient by reducing price discrepancies.
Liquidity: Arbitrage can add liquidity to markets.

Arbitrage in Different Markets

Financial Markets: Stock, bonds, commodities, etc.
Foreign Exchange Markets: Arbitrage between currency pairs.
Cryptocurrency Markets: Price differences across various crypto exchanges.
Retail and Online Markets: Buying low from one retailer and selling high on another platform.

Limitations and Criticisms

Barriers to Entry: High costs and technological requirements can prevent retail investors from participating.
Short-lived Opportunities: Arbitrage opportunities are often quickly corrected.
Regulatory Risks: Some forms of arbitrage may border on market manipulation, subjecting the arbitrageur to legal risks.